Here’s a price check on high-flying dollar-store stocks

Ever since the Great Recession, it's been up, up, up for the most downscale retailers.

At this point, wise shoppers might want to stop and demand a price check on those high-flying dollar-store stocks.

Share prices in the sector are already elevated and they received an additional boost on Monday from Dollar Tree Inc.'s $8.5-billion (U.S.) cash-and-stock offer for rival Family Dollar Stores Inc. Adding to the excitement, some observers speculated that Dollar General Corp., the heavyweight in the sector, could rush into the fray with a bid of its own.

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Before getting caught up in the takeover drama, investors should step back and consider the grinding realities of a sector that depends upon the poor and the just-getting-by for a hefty chunk of its clientele.

Dollar stores, as a rule, did not grow all that quickly during the prosperous years before the Great Recession. They shifted into overdrive with the arrival of the downturn, but have recently seen their growth slow as the market becomes increasingly crowded and other merchants target the same low-priced, disposable products as dollar retailers.

Investing in the sector now requires faith that dollar stores will be able to compete against the likes of Wal-Mart Stores Inc. and Target Corp., both of which are introducing smaller stores that will tread on dollar stores' traditional turf.

It also demands conviction that the sector won't be hit by an unexpected outburst of better economic times. A pick-up in the recovery could send many shoppers back to the relative luxury of Wal-Mart or Costco.

The risks of the dollar-store industry aren't reflected in the sunny valuations being applied to the sector. The leading chains in the industry – Big Lots Inc., Dollar General, Dollar Tree, Family Dollar, Five Below Inc. and Canada's own Dollarama Inc. – trade at price-to-earnings mutiples that are equal to or above those of much bigger discounters such as Wal-Mart and Target.

Those multiples are deserved only if the dollar stores can keep expanding more quickly than the big guys. To their credit, the dollar merchants have been able to expand sales by a cumulative total of about 12 per cent over the past three years while the big discounters have struggled to maintain revenue.

There's no doubt that many of the dollar-store chains are talented retailers and each provides its own spin on catering to a budget demographic. Dollar Tree, for instance, sticks to selling goods that cost a dollar or less, while Family Dollar ranges higher and sells discounted name-brand food, among other things.

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Analysts tend to be bullish on the industry with some companies, such as Dollarama, being special favourites. The constant theme in their reports is that many shoppers are strapped for cash and enjoy the small luxuries and convenience of dollar stores.

The issue, though, is that dollar stores are now big enough to draw competition, but not big enough to enjoy the buying power of the largest merchants. In fact, the six biggest dollar-store companies have a combined market capitalization of roughly $48-billion – or about 20 per cent of Wal-Mart's.

It's not clear why investors should pay a premium for a sector that is likely to be buffeted by increasing competition from bigger competitors in coming years. Unlike other retailers, dollar stores don't have an obvious way to expand into internet sales.

For now, the excitement is more about cost savings than huge new growth opportunities. The merger of Dollar Tree and Family Dollar is expected to result in $300-million in savings within three years, which could justify the 23-per-cent premium that Dollar Tree is paying for its rival.

That makes the deal understandable. But it shouldn't entice investors in search of a bargain.

Ian McGugan is a reporter with The Globe and Mail's Report on Business and has been writing about investing, economics and business for more than 20 years. He joined the Globe and Mail in 2010. He has been executive editor of Canadian Business magazine and founding editor of MoneySense magazine. More

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